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Predicting Your Company’s Financial Health with Balance Sheet Forecasting

In the past many financial professionals were reluctant to conduct balance sheet forecasting. The process was tedious and time consuming – especially if relying on spreadsheets – and further compounded by the knowledge that no matter the effort the forecast would never be 100 percent accurate.  The reality however is that forecasts are not about being “right” but about offering better insight into the future financial health of the organization.  That level of detail is something every organization regardless of size, industry, or business model, needs in order to compete in today’s complex and competitive business world.

The budgeted income statement allows a company to forecast most of its operations, such as sales with its associated costs, operating expenses, including payroll and its related expenses and anything one would normally see on an income statement. However, unless there is a forecasted balance sheet, closely integrated to the budgeted income statement there is little value in just getting a complete and accurate forecast of your P&L. Think of your own ERP or accounting software where the balance sheet is seamlessly produced and follows the activities in the P&L, as well as directly receives entries into its own GL accounts -- integration is critical!

Forecasting the Profit & Loss (Income Statement) is simply not enough. Can you say with confidence that you’ll be able to execute on the items forecasted within the P&L?  Will you have sufficient cash to purchase inventory for the projected growth or that new product line you are so eager to launch mid-year of your forecast?  What about the additional workforce in your forecast; will you have the cash to support these new hires?  Will you be able to finance a needed expansion?  Will you have to sell additional equity in the business?  Issue more debt?  Sell assets? Will you have to use one, two or more of these methods and when, during the forecasted period?

None of these questions can be accurately and honestly answered without having visibility into a forecasted balance sheet.  For this forecasted balance sheet to work well and be meaningful it must be tightly linked to your plan and budget in a way that every budget line affecting the forecasted income statement and all existing business rules must seamlessly affect the forecasted balance sheet.

For example, consider that sales on credit generate accounts receivable in the period products were shipped or services were provided.  The forecasted balance sheet (A/R balances and Retained Earning – Current) needs to reflect that, taking into account all of your credit sales to all of your customers, at the right prices and the right terms.  Then forecasted cash and A/R must automatically reflect collections from these customers, according to forecasted payment terms, which may differ from customer to customer. 

At the same time, forecasted expenses on the P&L will require cash.  This cash will have to be disbursed according to forecasted purchases and specific payment terms as dictated by suppliers. Other cash disbursements to employees, taxes, purchases of assets and other expenses shown on the forecasted P&L will also need to be considered and shown on the forecasted balance sheet (and Statement of Cash Flows).

Only then, when you have forecasted cash receipts and cash requirements (represented by the ending cash balance in each forecasted balance sheet period, as well as the output from a forecasted Statement of Cash Flows), will you know whether or not your plan and budget are feasible and what needs to be done to prepare for execution of the plan.

The above example can be carried through to all other sections and elements of the balance sheet.  As in actual accounting, every forecasted activity that appears on the budgeted income statement, must automatically find its way to the forecasted balance sheet and from there, automatically contribute to the creation of a forecasted Statement of Cash Flows.

It’s worth noting that it is downright impossible to create and maintain a budgeted balance sheet in a set of spreadsheets.  Technology tools have come a long way and today there are budgeting and forecasting applications that can create and maintain a meaningful balance sheet, yet do not require user-designed formulas, functions, links or other time consuming programming code.

Not forecasting a complete balance sheet is a risky proposition in today’s business environment. Every organization that engages in building and maintaining a budget should have visibility into its future balance sheet. By going beyond the P&L statement and forecasting the balance sheet, financial professionals can help predict the future financial health of the company and provide the visibility needed to stay competitive and successful.

Alan Hart is a former CFO with more than 30 years of experience in accounting, finance and management, and he currently works with Centage Corporation to evangelize driver-based budgeting and forecasting solutions.

Comments

Warren Miller
Title: Cofounder
Company: Beckmill Research, LLC
(Cofounder, Beckmill Research, LLC) |

Thank you, Alan, for an insightful posting about a crucial and neglected topic. You're right in your question about funding growth. Only a balance sheet forecast will start to answer that question. Truth be told, it's not difficult, even in a spreadsheet.

I hasten to add that I am NOT talking about "maintaining a budgeted balance sheet in a set of spreadsheets." No way. I'm talking about a sanity check on a P&L forecast of aggressive growth. On a pure operating basis, companies that sell products, whether they make or distribute them, invariably have Cash Flows from Operations that lag Net Income, sometimes big-time. The growth in A/R and inventory outruns the breathing room afford by increases in A/P.

So I agree with you about taking it one step further: Once the forecasted balance sheet is in place, do a pro-forma Statement of Cash Flows. That's really where the accounting chickens come home to roost, as we all know. For high-growth SMEs, this is especially important. Yet I can count on the fingers of one hand the number of companies I've met over the last 25 years that give me the thousand-mile stare in the four-foot room when I ask if they've 'touched base with the funding reality imposed by an aggressive growth forecast.'

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